Another Step Toward a Derivatives Blow-Up?

As of June 10, most swaps on interest rates and credit defaults in the U.S. will have to be cleared through central exchanges.

I’ve discussed before the critical implications of these new rules. This is a huge market… the notional amount of these swaps floating around the world is $395 trillion.

Previously, these derivatives were traded direct party-to-party. No one really knew what trades were happening, or at what price.

With central clearing, everyone will now find out. Prices for all cleared transactions are reported in real-time.

This means price discovery. Which means firms holding derivative portfolios will have to mark to market the value of these instruments.

Today’s implementation covers commodity pools, private funds, and banking entities making swaps trades. Other groups like swap dealers and swaps-focused funds were required to start clearing this past March. But today’s tranche is a much larger segment of the overall market. (A final deadline is coming on September 9 for a few hold-out traders, such as some pension funds.)

What could the effect of mark-to-market be? The gross market value of these swaps is estimated at nearly $18 trillion globally. A 10% write-down on these assets would be a $1.8 trillion loss. Roughly equal to the monies paid out by the U.S. government during the post-2008 bailout.

Pricing in the swaps market has been opaque for a long time. Many firms likely took advantage, carrying their portfolios at the highest values possible. That opportunity is now gone. Pricing going forward will be decided by the cold, hard hand of the market.

We’ve only got a few weeks left in Q2. So we may not see any major impact within upcoming financials from banks and other swaps traders. But keep an eye out for emerging signs of problems. Particularly as we head into Q3, where the full brunt of the new regulations will be felt.